The Convergence of Factors Limiting Inflation Are Now Diverging

The last twenty-five plus years have seen a convergence of numerous factors that contributed to a contained low inflation environment.  As much as we would like to live in the past or extrapolate old trends into perpetuity, we must acknowledge changes and extrapolate new trends into the future to survive and prosper.

There are many factors that have contributed to low levels of inflation in the US.  One of the biggest contributors has been low wage pressures.  Trade policies of the past gave labor arbitrage opportunities to large companies to move operations overseas leading to the importing of goods and services back into the US.  This is a large part of today’s trade deficit.  These competitive pressures limited labor’s bargaining power and companies had limited economic ability to reward workers with higher pay.  Overblown fears of a brittle economic environment and the ease of finding and replacing workers has assisted as well.

Lower interest rates have also assisted in lower levels of inflation.  Lower rates have put downward pressures on corporate, government and individual costs.  Corporations responded by passing these lower interest costs through to lower priced goods and services and competitively garner a larger share of the economic pie.  Lower rates enabled governments keep taxes relatively low limiting needs for higher wages.  Lower interest rates also put downward pressure on costs of housing ownership and rentals.  This lower headline inflation environment made labor low pay increases palatable and possible.  And the monetary impact of a slower economy from lower interest rates and less disposable income to spend helped constrain inflation as well.

Technological advancements and other increases in productivity assisted greatly to produce more, from further away places at lower costs.  This rapid explosion in technological advancements has helped subdue inflation to limits still not fully understood.

And governments have become more creative in their calculation methodologies employed that not only lower stated inflation levels, but also diminish the volatility in those levels calculated.  Hedonic pricing adjusting for a subjective perceived quality difference and substitution adjustments pulling high inflation items out of the measurement population ensures even higher levels of inflation are not reported.  Yes, the public is living with much higher costs of living adjustments every year than the official inflation statistics report.  This lower headline level of inflation limits the psychological impact of pass through inflation of labor or other goods and services demanding higher prices.  This psychological impact only diminishes the pass through of labor for short to medium term time frames.  Eventually, the pass through of higher prices become a necessity regardless of officially reported metrics.

Yes, it was a good 25 years that saw trend inflation decline to the lower levels of 1 to 2% of the last few years.  That is over - stop living in the past! 

Companies that start testing the waters of higher prices for goods and services will be pleasantly surprised with the results.  They will be rewarded higher margins from passing along higher input costs.  Labor should also test the waters and push for higher pay.  It is an acceptable environment and higher wage demands will be tolerated well.  Most companies have more to lose with disrupted supply and employee search costs. 

And this couldn’t be a better time to lock in low long term rates and load up on long term productive assets.  The global symphony of low long term rates for the last decade may be on its last legs.  An abundance of supply, limited tangible risks, minimal manipulation by the Fed and percolating inflation are all converging in what may be the perfect storm in an overvalued bond market.  This could propel long term interest rates out of the era of cheap funding and over-valued debt markets.

It is often difficult to see change coming.  However, the changing inflation landscape is as clear as day.  A year from now, with hindsight being 20-20, the world will largely say, yes, we saw the changing inflationary landscape coming.  And the world will probably also say, we wish we did something proactive about it.

by Michael Carino, Greenwich Endeavors, 6/24/18

Michael Carino is the CEO of Greenwich Endeavors and has been a fund manager and owner for more than 20 years.  He has positions that benefit from a normalized bond market and higher yields.